Congressional panel warns that if unemployment remains high and the property market continues to crumble, banks will still incur further losses on bad assets.

Toxic assets on the balance sheets of hundreds of American banks remain a “substantial danger” to the financial system and could yet drive institutions to collapse, a congressional watchdog warned on Tuesday in a report urging against any complacency that the banking crisis may be drawing to a close.

A congressional oversight panel charged with scrutinising the Treasury’s $700 billion (£423 billion) bailout efforts said smaller banks, which were not examined in recent government “stress tests”, are at particular risk as the ongoing US recession pushes an increasing number of commercial property loans into default.

The panel warned that if unemployment remains high and the property market continues to crumble, banks will still incur further losses on bad assets: “The financial system will remain vulnerable to the crisis conditions that Tarp [the Treasury’s bail-out program] was meant to fix.”

Elizabeth Warren, the panel’s chairman, said the underlying value of assets on banks’ balance sheets remained uncertain, with many loans proving almost impossible to sell.

“No one has a good handle how much is out there,” said Warren. She cited estimates that toxic assets amount to between $600 billion and $1.5 trillion, observing, “that’s a lot.”

Since the banking crisis blew up in September, the US government has pumped capital into leading institutions and has heightened scrutiny of banks’ capital ratios. But a public-private partnership to pluck troubled assets from banks’ balance sheets, which was a centrepiece of treasury secretary Timothy Geithner’s strategy, has failed to generate much momentum.

“The problem of troubled assets is especially serious for the balance sheets of small banks,” said the panel, which pointed out that these institutions generally held entire toxic loans, rather than sliced and diced mortgage-backed securities which have been the target of most Treasury clean-up efforts.

Frozen Assets

Meanwhile, Citigroup got an unwelcome reminder of the legacy of its activity at the height of the financial boom as it was sued by seven tiny Norwegian towns which lost millions on investments in risky derivatives.

The towns all have fewer than 33,000 residents and have filed a joint lawsuit with Terra Securities, a bankrupt Norwegian broker, claiming damages of $200 million from Citigroup.

“Citigroup’s marketing materials contained misleading statistics that concealed from both Terra and the municipalities the significant risks inherent in the fund-linked notes,” said Jon Skjorshammer, a lawyer representing the plaintiffs.

The towns include Narvik, a community north of the Arctic Circle with fewer than 20,000 residents which has had to borrow money to pay public employees, and Hattfjelldal, which has barely 1,500 residents but which reportedly invested 103 million Norwegian kroner (£10m). They were sold leveraged investments in US municipal bonds marketed through Terra Securities by Citigroup.

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